The cost of real estate has surged dramatically over the last decade, but especially over the last 12 months. In fact, a recent report from the National Association of Realtors showed the median existing-home sales price rose at a year-over-year pace of 17.8% from August 2020 to August 2021.
If you’ve been sitting on the sidelines and waiting until you can afford the home you want, rising real estate prices can seem particularly troubling. You might also be rethinking your strategy and goals, or trying to figure out whether you can spend more than you originally thought.
You probably have dozens of questions swirling through your head as well. For example:
How much can I afford for a house? Also, how much will a mortgage company actually lend me?
Unfortunately, what the mortgage company says and what you can comfortably afford aren’t always the same.
This guide aims to explain how to figure out how much house you can actually afford, and not just what the mortgage company says. If you’re ready to dive into the real estate market before prices head to the moon, read on to learn more.
How Lenders Decide How Much Home You Can Afford
When you apply for a mortgage so you can purchase a home, lenders look at an array of important factors including your credit score, your income, and your other debts. They also use a specific metric known as debt-to-income ratio (DTI) to gauge how much they can reasonably lend you.
Debt-to-income ratio (DTI) may sound like a fancy term, but it’s really nothing more than your monthly expenses compared to your monthly gross income. You can determine your DTI by dividing your monthly debts by your gross monthly income.
For example, someone with a gross monthly income of $10,000 and monthly expenses of $3,500 would have a debt-to-income ratio of 35%. The calculation used to reach this figure looks like this:
$3,500 / $10,000 = 0.35%
Enter a general rule known as the “29/41 rule.”
Generally speaking, mortgage lenders want to ensure your overall debt-to-income ratio is no more than 41%, and that your housing payment makes up no more than 29% of that amount.
With a gross monthly income of $10,000 (or $120,000 per year), your mortgage payment (including principal, interest, taxes and insurance) should be no more than $2,900, while your total debts combined should cost you no more than $4,100 per month.
If you earn half of that, or $5,000 per month, your mortgage payment (including principal, interest, taxes and insurance) should be no more than $1,450, while your total debts combined should cost you no more than $2,050 per month.
Which debts count as “other debts?”
This metric can include any debts you have to pay each month, but is usually made up of car payments, payments on credit cards, student loans, and more.
With all this being said, you should note that the 29/41 rule is just a general rule of thumb. Some lenders may let you borrow slightly more or slightly less, and some types of home loans (VA loans, FHA loans, etc.) come with different requirements.
Other Home Affordability Factors
Now that you know what lenders will look at, you should dive deeply into other factors that can impact how much you can (and really should) borrow.
The following details are worth considering as you begin searching for a new home and a new home loan to go with it.
Your down payment can have a significant impact on the amount of money you can borrow for a home. Obviously, having a larger down payment can help you borrow more since it frees up space in your DTI, whereas a smaller down payment for your home means you can borrow less.
Most experts suggest putting down at least 20% on your new home, and for more reasons than one. First, having a down payment of 20% can help you avoid a situation where you’re “underwater” on your mortgage if housing prices go down. Second, putting down 20% or more helps you avoid paying private mortgage insurance (PMI) on your home loan.
With a down payment of less than 20%, the PMI you pay typically tacks on another .5% to 1% on your mortgage payment until you have sufficient equity to drop private mortgage insurance. This is money down the drain, but the added costs can also impact the amount of the home loan you’re eligible for.
Mortgage Interest Rates
Another huge factor that impacts home affordability is the interest rate on your mortgage, but this is one area where you have a tremendous advantage right now. Mortgage rates are nearing record lows, and paying less interest each month means you can afford to borrow more money upfront.
How do mortgage interest rates affect your housing payment? Consider this example, which only looks at the principal and interest components of a loan (excluding other costs like property taxes and insurance).
If you borrowed $400,000 for a home on a 30-year fixed-rate mortgage at 4%, the monthly payment (principal and interest) works out to $1,909.
With the same loan amount and term and an interest rate of 3%, the monthly payment (principal and interest) works out to $1,686.
If you were able to secure the same loan with an interest rate of 2.5%, the monthly payment (principal and interest) works out to $1,580.
You get the point. The lower interest rates go, the lower your payment goes. This frees up more room to borrow while keeping your debt-to-income ratio (DTI) at an acceptable level for lenders.
But, what about the length of your mortgage? The question, “How much of a house can I afford?” cannot truly be answered until you know how long you want to spend paying your home off.
If you’re willing to go with a longer 30-year loan term, you’ll be able to secure a lower monthly payment and potentially be able to borrow more as a result. Just keep in mind that mortgage rates for longer home loans tend to be slightly higher.
How much difference can your mortgage length make? Actually, quite a bit.
We already mentioned how borrowing $400,000 for a home on a 30-year mortgage at 3% would leave you with a monthly payment (principal and interest) of $1,686.
If you switch to a 15-year home loan with the same fixed interest rate, your monthly payment (principal and interest) goes up to $2,762 but your loan lasts half as long.
If you get a slightly lower rate of 2.5% on a 15-year loan in this amount, which is likely, your monthly payment (principal and interest) goes down to $2,667.
These examples don’t take into account the other mortgage lengths that may be available to you, or mortgages that come with variable interest rates that change over time. However, it’s true across the board that a longer loan term yields a lower monthly payment, which can help you buy more house upfront.
Additional Home Expenses
Additional expenses can impact how much you can borrow for a new home, and many of them are largely beyond your control. Some additional home expenses to consider include the following:
Property Taxes: Property taxes are typically paid out of the escrow account your lender sets up for your mortgage, yet you’ll pay into that escrow account on a monthly basis. By and large, higher property taxes make you pay more in each month, causing your monthly housing payment to balloon. If you live in an area with lower property taxes, on the other hand, the impact on your monthly payment won’t be so great.
Homeowners Insurance: Homeowners with a mortgage need to have homeowners insurance, which is typically paid for out of their mortgage escrow account. Once again, a proportionate amount is paid in each month, which impacts your mortgage payment.
HOA or Condo Dues: If you live in a neighborhood with a homeowners association (HOA) or you own a condo, you may owe a monthly amount toward membership. This amount can also impact how much you can borrow for a home.
Maintenance and Upkeep
If you’ve always rented and never owned, you will also need to mentally account for ongoing maintenance costs and repairs. These expenses won’t be reflected in your mortgage amount, but you need to plan for them nonetheless.
For example, a home with an older roof or HVAC will need pricey upgrades within a few years. Plus, you’ll have to think about lawn care, landscaping, the cost of servicing your heating and air conditioning, and more.
How You Can Decide How Much Home You Can Afford
All things considered, you should also know that the mortgage company doesn’t know your entire situation. They use algorithms and ratios to decide how much they think you can borrow, but they have no idea how realistic that number is for your personal finances and other expenses you have.
For example, you may be someone who has low expenses on paper but pricey indulgences in real life. Maybe you don’t have a car payment but you have three kids in expensive sports clubs that cost an arm and a leg. These other expenses wouldn’t show up in your debt-to-income ratio (DTI), but that doesn’t mean they’re not important to your family.
On the other hand, maybe you have big financial goals you want to achieve, including an urge to become debt-free or retire early.
In that case, you may want a lower monthly mortgage payment than the mortgage company decides. Or maybe you want to go with a 15-year home loan so you can pay your house off faster and retire at 55.
Either way, you really need to decide what you can afford to pay each month without putting your family finances in peril or sacrificing other goals.
The Bottom Line
How much home you can afford depends on your income, the mortgage interest rate you can qualify for, the length of your home loan, and other important factors. However, it also depends on how much you feel comfortable paying, and how much money you want leftover to save, invest, or spend living the lifestyle you want.
The 29/41 rule is a good place to start the process, but you should take a look at your monthly budget and spending habits to see what you are truly comfortable with.
The mortgage company should not be in charge of your future mortgage payment. They can give you an idea, but the decision is ultimately yours.
Frequently Asked Questions (FAQ)
Will mortgage rates go down?
Mortgage rates go up and down based on factors like the prime rate. However, current interest rates are at or near record lows, so they are more likely to go up over time than they are to drop further.
If you plan to purchase a home, your best bet is getting pre-qualified with one of the top mortgage lenders now so you can lock in today’s low rates.
How do I choose a mortgage lender?
There are numerous mortgage lenders to choose from, and it can be difficult to decide. We suggest shopping around with lenders to find out which one offers mortgages and loans with the lowest interest rates and closing costs.
What credit score do I need to buy a house?
According to Rocket Mortgage, consumers are most likely to qualify for a mortgage if they have a credit score of 620 or higher. However, you may be able to qualify for an FHA home loan with a credit score as low as 580. The same standard applies for most VA home loans.
Can I buy a house without a down payment?
According to the Consumer Financial Protection Bureau (CFPB), most traditional lenders require borrowers to have a down payment of 5% to 15%. Borrowers can also qualify for a FHA home loan with as little as 3.5% down.